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Momentum Strategies in Commodity Futures Markets

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Momentum Strategies in Commodity Futures Markets EDHEC RISK AND ASSET MANAGEMENT RESEARCH CENTRE 393-400 promenade des Anglais 06202 Nice Cedex 3 Tel.: +33 (0)4 93 18 32 53 E-mail: [email protected] Web: www.edhec-risk.com Momentum Strategies in Commodity Futures Markets Joëlle Miffre Associate Professor of Finance, EDHEC Business School Georgios Rallis Cass Business School, Ph.D. Student ABSTRACT The article tests for the presence of short-term continuation and long-term reversal in commodity futures prices. While contrarian strategies do not work, the article identifies 13 profitable momentum strategies that generate 9.38% average return a year. A closer analysis of the constituents of the long-short portfolios reveals that the momentum strategies buy backwardated contracts and sell contangoed contracts. The correlation between the momentum returns and the returns of traditional asset classes is also found to be low, making the commodity-based relative-strength portfolios excellent candidates for inclusion in well-diversified portfolios. Keywords: Commodity futures, Momentum, Backwardation, Contango, Diversification JEL classification codes: G13, G14 Author for correspondence: Joëlle Miffre, Associate Professor of Finance, EDHEC Business School, 393 Promenade des Anglais, 06202, Nice, France, Tel: +33 (0)4 93 18 32 55, e-mail: [email protected] A version of this paper is forthcoming in the Journal of Banking and Finance. The authors would like to thank Chris Brooks and two anonymous referees for helpful comments. EDHEC is one of the top five business schools in France owing to the high quality of its academic staff (104 permanent lecturers from France and abroad) and its privileged relationship with professionals that the school has been developing since its establishment in 1906. EDHEC Business School has decided to draw on its extensive knowledge of the professional environment and has therefore concentrated its research on themes that satisfy the needs of professionals. EDHEC pursues an active research policy in the field of finance. Its “Risk and Asset Management Research Centre” carries out numerous research programs in the areas of asset allocation and risk management in both the traditional and alternative investment universes. 2 1. INTRODUCTION Commodity futures are excellent portfolio diversifiers and, for some, an effective hedge against inflation (Bodie and Rosansky, 1980; Bodie, 1983). They also offer leverage and are not subject to short-selling restrictions. Besides, the nearby contracts are typically very liquid and cheap to trade. For all these reasons, commodity futures are good candidates for strategic asset allocation and have been proved to be useful tools for alpha generation (Jensen et al., [2002]; Vrugt et al., [2004]; Wang and Yu, [2004]; Erb and Harvey, [2006]). This article examines the profitability of 56 momentum and contrarian strategies in commodity futures markets. The momentum strategies buy the commodity futures that outperformed in the recent past, sell the commodity futures that under-performed and hold the relative-strength portfolios for up to 12 months. The contrarian strategies do the opposite. They buy the commodity futures that underperformed in the distant past, sell the commodity futures that outperformed and hold the long-short portfolios for periods ranging from 2 to 5 years. To put this differently, the article investigates whether the short-term price continuation and the long-term mean reversion identified in equity markets by Jegadeesh and Titman (1993, 2001) and De Bondt and Thaler (1985) are present in commodity futures markets. The paper also builds on the research of Erb and Harvey (2006) who show that a momentum strategy with a 12-month ranking period and a 1-month holding period is profitable in commodity futures markets. While contrarian strategies do not work, the article identifies 13 profitable momentum strategies in commodity futures markets. Tactically allocating wealth towards the best performing commodities and away from the worst performing ones generates an average return of 9.38% a year. Over the same period, a long-only equally- weighted portfolio of commodity futures lost 2.64%. In line with the analysis of Erb and Harvey (2006), this result suggests that active investment strategies have historically been profitable in commodity futures markets. While they are not merely a compensation for risk, the momentum returns are found to be related to the propensity of commodity futures markets to be in backwardation or in contango. The results indeed suggest that the momentum strategies buy backwardated contracts and sell contangoed contracts. Therefore our analysis indicates that one can link the momentum profits in commodity futures markets to an economic rationale related to the Keynes (1930) and Hicks (1939) theory of normal backwardation. Interestingly, the momentum returns are also found to have low correlations with the returns of traditional asset classes, making the commodity-based relative-strength strategies good candidates for inclusion in well-diversified portfolios. There are strong rationales for implementing momentum strategies in commodity futures markets rather than in equity markets: Our commodity-based long-short strategies minimise transaction costs,2 trade liquid contracts with nearby maturities, are not subject to the short-selling restrictions that are often imposed in equity markets and focus on 31 commodity futures only (as opposed to hundreds or thousands of stocks). It is therefore unlikely that the abnormal returns we identify will be eroded by the costs of implementing the momentum strategy or will be a compensation for a lack of liquidity (as in Lesmond et al., 2004). On a less positive note, institutional investors who implement momentum strategies in commodity futures markets have to post initial margins, monitor margin accounts on a daily basis, roll-over contracts before maturity and pay margin calls. As they are not born by equity asset managers, such costs have to be weighed against the benefits of implementing momentum strategies in commodity futures markets. The margin calls and roll-over risk, however, should not be overstated: as the momentum strategies buy backwardated contracts and sell contangoed contracts, little to no cash will be required for margin calls and the roll-over trades will be more often than not profitable. The article proceeds as follows. Section 2 introduces the dataset. Section 3 outlines the methodology used to construct momentum and contrarian portfolios. It also presents the risk models that are employed to 1 - The term “return” is used loosely to refer to the performance of the momentum and contrarian strategies. It is noted that the term is improper in futures markets as, aside from the initial margins, no cash payment is made at the time the position is opened. It follows that a definition of returns that implicitly assumes that investors purchase the futures contract at the settlement price is, by definition, inaccurate. Note however that a definition that considers the initial margin as an investment is also incorrect since the initial margin is just a good faith deposit (and not an investment) and is redeemed to the trader (along with accrued interests and marking-to-market profits or losses) at the time he/she enters a reversing trade. Based on this and in line with, among others, Dusak (1973) and Bessembinder (1992), the paper measures futures returns as the change in the logarithms of settlement prices. Had futures returns been measured relative to the margins and on a fully-collateralized basis, the momentum profits would have been further enhanced. Our definition of return is free of collateral and therefore more conservative. 3 2 - Transaction costs in futures markets range from 0.0004% to 0.033% (Locke and Venkatesh, 1997), which is much less than the conservative 0.5% estimate of Jegadeesh and Titman (1993) or the more realistic 2.3% estimate of Lesmond et al. (2004) for the equity market. measure the abnormal returns of the strategies. Section 4 discusses the results from the momentum strategies. In particular, it highlights the relationship between momentum profits, backwardation and contango and the diversification properties of the momentum portfolios. Section 5 focuses on the contrarian strategies. Finally, section 6 concludes. 2. Data The data, obtained from Datastream International, comprises settlement prices on 31 US commodity futures contracts. We consider 13 agricultural futures (cocoa, coffee C, corn, cotton #2, milk, oats, orange juice, soybean meal, soybean oil, soybeans, sugar #11, wheat, white wheat), 4 livestock futures (feeder cattle, frozen pork bellies, lean hogs, live cattle), 6 metal futures (aluminum, copper, gold 100 oz, palladium, platinum, silver 1000 oz), 5 oil and gas futures (heating oil, light crude oil, natural gas, regular gas, unleaded gas) and the futures on diammonium phosphate, lumber and western plywood. The dataset spans the period January, 31 1979 to September, 30 2004. To avoid survivorship bias, we include contracts that started trading after January 1979 or were delisted before September 2004. We mitigate problems of low liquidity and high transaction costs by filtering out futures with average trading volume below 1,000 contracts over the period January, 31 1979 to September, 30 2004.3 The total sample size ranges from a low of 22 contracts at the beginning of the period to a peak of 27 contracts over the periods March 1996-July 1997 and July 1999-September 2004.4 The paper tests the sensitivity of the results to the technique employed to compute futures returns. Two approaches are used to compile time series of futures prices and, consequently, time series of futures returns. In both cases, futures returns are computed as the change in the logarithms of the settlement prices. First, we collect the futures prices on all nearest and second nearest contracts. We hold the first nearby contract up to one month before maturity. At the end of that month, we roll our position over to the second nearest contract and hold that contract up to one month prior to maturity.
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